ESG and Sustainable Investment

March 1, 2023

Carla Cico, Vice- Chairman of the Board, Olympia Group (Greece)

Only a little more than 20 years have passed since the Enron and WorldCom bankruptcy scandals that, among other ramifications, forced the wholesale revision and reinforcement of Corporate Governance and Risk Management. New legislation and financial reporting requirements were enacted to expand the accuracy of financial reporting for public companies. It is now hard to believe how much the business environment has changed in such a short period. If you look at the growth in both quantity and intensity of Corporate Governance (and now ESG) requirements, it might as well have been a lifetime.

Corporate governance becomes ESG

At the beginning, Corporate Governance was mainly focused on the financial aspects of businesses, aiming to ensure the transparent disclosure of data in order to avoid fraud. Over the years, however, Corporate Governance began to encompass social and environmental issues, with a notable acceleration in scope within the last 10 years, resulting in the form of Environmental, Social and Governance (ESG) we know today.

In the wake of the Global Financial Crisis of 2008, perceptions of business success started to be re- evaluated by society and also governments. There was a shift to a values-based approach and the growing expectation that business can and should play a core role in solving the biggest problems facing the world.

But what is the reality behind these expectations, for businesses, investors, government regulators, and consumers? Here I will try to unravel the complexity of ESG, which is probably the most used (and abused) phrase in the global corporate environment. It features regularly in pronouncements by regulators, the investing community, and political figures, in a variety of ways, and with different meanings. Furthermore, and most importantly, ESG and/or the lack of it, has become an important factor in choices by consumers.

An ESG based growth strategy

There is no doubt that Corporate Governance/ESG has brought benefits to the business world: they force organizations to adapt more disciplined governance protocols, as well as imposing more transparent processes.

These benefits have quantitative value: for example, the investor community is willing to pay a higher price for a company that has proper ESGs in place. Underlying this behavior is a generally accepted sentiment that if a company is focused on implementing ESG in full, it is a company that is likely to create more valuable returns for its stakeholders.

Today ESG considerations must be factored into almost every business decision. Increasingly, an organisation’s ESG performance will affect everything from the cost and availability of capital to its ability to attract talent and the reliability of its supply chain.

Global investment management firm BlackRock, for example, now applies a method of ‘sustainable investing’ to define the practice of analysing a company’s ESG risks, to inform the allocation of capital. Dramatic changes in the climate, society and transparency requirements in many countries have moved ESG from the periphery to the core of decision-making for organisations and stakeholders.

New knowledge and skills are required of senior management and Board members, who need to be able to understand a range of technical issues, from climate science to data and privacy protection, to inform their business strategy and priorities.

The risks associated with ESG

The benefits of ESG also bring with them considerable new areas of risk and cost which need to be understood and factored into the overall business strategy. This is not only the case for large organisations, but importantly also for Small and Medium Enterprises (SMEs) as well.

Regulators, supported by governments, are continuing to impose new rules on companies – regardless of their size – with significant penalties for companies that fail to implement them. Yet such an approach seems to ignore the fact that the implementation of ESG standards does not come free of charge. Indeed, it is exactly the opposite: implementing ESG standards is not only costly in financial terms, but also from an organizational point of view.

Beyond the dollars and cents, companies are facing a skills shortage. It is difficult to find people with the right skills and experience to ensure compliance with these new standards. Developing and retaining these competencies in-house is also difficult due to the competition for these individuals and the ever- increasing demand. As regulatory and compliance requirements increase, many companies are forced to turn to external consultants to plug the skills gap. Business schools have recognized this changed business environment and many are transforming their MBA courses to reflect the new pressures and demands on business leaders in relation to ESG. It is hoped that this will over time expand the number of available talent in the field.

While large organizations or those that operate on a multinational level can absorb such costs without sacrificing other investments, many SMEs face a difficult dilemma: do they reduce their investments or skimp on the implementation of ESG standards, and if so, what are the downside risks of both?

The penalties for the latter are clear and immediate: companies can face harsh fines, public backlash, and regulatory investigations. Yet the decision is not so simple – if a firm decides to opt for the former, the reduction in investments bring the risk of future losses in competitive advantage, hence putting at risk long- term business growth or even overall business survival. No matter the choice, there will always be a cost, and the difference in timescales associated with each approach may obscure the true magnitude of the cost.

We need a new approach to ESG

In light of the above, it may be time to review the current overly enthusiastic and one-sided approach to ESG regulatory standards, which over time is becoming more and more difficult to justify and meet. Instead, ESGs should be tailored and refocused on what really matters: the shaping of business activity to maximize the overall benefits for all stakeholders, whether they be shareholders, employees, or consumers. With this different approach, it will be possible to consider the potential adverse impact on an SME’s future sources of competitive advantage. To avoid these negative impacts, regulators should also take into consideration the financial capabilities of each company to avoid forcing these businesses into decisions which will negatively impact their future growth prospects.

Professor of Finance at the University of Colorado at Boulder, Sanjai Bhagat, in an article published in the Harvard Business Review1 warns of the dangers and unintended consequences of over regulation of ESG compliance. While investing in sustainable funds that prioritize ESG goals is supposed to help improve the environmental and social sustainability of business practices, it may actually be directing capital into poor business performers. “In competitive labor markets and products markets, corporate managers trying to maximize long-term shareholder value should of their account pay attention to employee, customer, community, and environmental interests. On this basis, setting ESG targets may actually distort the decision- making process.” In setting ever-more- onerous ESG standards, are we really maximizing Environmental, Social, and Governance value?

We need a change in perspective: by transforming ESG regulation from a cost-imposing activity to a pro- business, individually tailored scheme, businesses would receive concrete incentives to participate while also maximizing their stakeholder benefits. One way that this could be achieved is through an “opt-in” tiered system where companies, in exchange for reaching certain “tiers” of ESG implementation, would gain access to benefits. Such a system would prescribe a mandatory “baseline” level which all businesses must comply with but would also provide criteria needed to access higher “tiers”. In exchange, businesses would be provided with different types of support, such as access to talent programs, long-term loans in the form of “green bonds” (spreading the costs of implementation over time), and carbon/emissions credits. Similarly, private actors such as investors and financial institutions could, for example, use these certifications to allocate higher investment ratings and/or loans at better conditions, while the companies themselves could integrate their “tier” into marketing and branding strategies.

Carla Cico, born in Verona, Italy, earned her MBA at London Business School. She has an extensive experience both as CEO ( she was the first South America female CEO in South America) and as a NED on Boards. She has been a pioneer in implementing Digital Transformation and ESG.

She is a speaker in many Summits, with focus mainly on Telecommunications, Management and Strategy, Digital Transformation, ESG and Developing Countries.